The Thompson Corporation projects an increase in sales from $1.5 Million to $2 Million but it needs an additional $300,000 of current assets to support this expansion. Thompson can finance the expansion by no longer taking discounts, thus increasing accounts payable. Thompson purchases under terms of 2/10, net 30, but it can delay payment for an additional 35 days - paying in 65 days and thus becoming 35 days past due - without a penalty because its suppliers currently have excess capacity. What is the effective, or equivalent, annual cost of the trade credit?
To calculate the effective annual cost of the trade credit, we need to consider the cost of the foregone discount and the cost of the delayed payment.
1. Cost of foregone discount:
The trade credit terms are 2/10, net 30, meaning Thompson can take a 2% discount if payment is made within 10 days. By delaying payment for an additional 35 days, Thompson will not be able to take advantage of the discount. So, the cost of the foregone discount is 2%.
2. Cost of delayed payment:
By delaying payment for an additional 35 days, Thompson is effectively extending its accounts payable by 35 days. Without the delayed payment, Thompson would have to pay in 30 days. Therefore, the cost of the delayed payment is 5/30 = 1/6 or approximately 17%.
3. Total cost of trade credit:
The total cost of trade credit is the sum of the cost of the foregone discount and the cost of the delayed payment. In this case, it is 2% (forgone discount) + 17% (cost of delayed payment) = 19%.
4. Effective annual cost:
To calculate the equivalent annual cost, we need to convert the cost of trade credit to an annual basis. Since the credit period is 35 days (the additional delay), we divide the total cost of trade credit by the number of periods in a year: 365/35 = 10.43.
Now, we can calculate the effective annual cost by multiplying the total cost of trade credit by the conversion factor: 19% x 10.43 = 198.17%.
Therefore, the effective, or equivalent, annual cost of the trade credit is approximately 198.17%.
To calculate the effective annual cost of the trade credit, we need to consider the cost of forgoing the discount and the cost of delaying payment.
1. Cost of forgoing the discount:
The terms are 2/10, net 30, which means Thompson can take a 2% discount if payment is made within 10 days. By not taking the discount, Thompson effectively pays an additional 2% on the purchase price.
2. Cost of delaying payment:
Thompson can delay payment for an additional 35 days without incurring any penalties. However, by delaying payment, Thompson effectively loses the use of that cash for 35 days.
To calculate the effective annual cost, we can use the formula for cost of trade credit (COTC):
COTC = [(1 + cost of forgoing the discount) / (1 - accounts payable period / accounts payable period + discount period)] - 1
Given:
Cost of forgoing the discount = 2%
Accounts payable period = 65 days (35 days past due + net payable days)
Discount period = 10 days
COTC = [(1 + 0.02) / (1 - 65 / (65 + 10))] - 1
= [1.02 / (1 - 65 / 75)] - 1
= [1.02 / (1 - 0.87)] - 1
= [1.02 / 0.13] - 1
= 7.84
Therefore, the effective annual cost of the trade credit for Thompson Corporation is approximately 7.84%.